Volatile Oil Prices Reflect A Systemic Problem

Benzinpreis 1994-2010

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Imagine that you had some money to invest last September, and that a financial advisor convinced you to buy crude oil futures. So you invested $10,000 in futures that were selling at $80 per barrel. You are now looking at that investment today, and you realize that it has done quite well. Your $10,000 is now worth about $14,000. You’ve made a forty percent profit in about 6 months. You’d be thrilled

Now consider the hand wringing that is going on right now about gas prices. The price of gasoline for ordinary Americans has risen dramatically.  The supply and demand of gas hasn’t really been pushing up the prices; it is speculators like you who have bid up the price. Is it your fault that unrest in the Middle East has made people willing to pay more for oil futures? Of course not. Is it your fault that you were lucky/smart enough to invest in this commodity at the right time? Of course not.

But the problem remains. When gas prices spike up dramatically, American’s hurt, and our economy suffers. The invisible hand of the free enterprise system is supposed bring more supply to the market when prices rise, and this is supposed to keep prices trading in a fairly narrow predictable range. Four years ago, oil began rising like it is today. It peaked at a level higher than today’s price.  Within a few months, however, it plunged from above $130 to just above $30 per barrel.

Now imagine that you are an executive at an oil company. Suppose you have the rights to drill in places that would cost $85 per each barrel to yield crude. With the price of crude trading at $112, that sounds like a pretty good deal. But if history repeats itself, and oil plunges again, then you might get stuck with a money-losing well. Would you begin to drill under that circumstance? Probably not.

Something is out of whack with oil prices.  Speculators drive the market and make it more volatile. This volatility hurts America.  But what difference does that make? The harm it does to America doesn’t motivate anyone to do anything differently. Would you sell your investment at significantly less than its market value just for the sake of helping the American economy?  I think not.

There are no villains in this story, but there is a harmful system in this story. The system of buying and selling oil futures is hurting America. No individual is doing anything wrong.  Everyone is following the rules. Free enterprise is not going to solve this problem for us. We need to stop our romantic reliance on free-enterprise to solve every economic problem. There are times when society needs to step in for the sake of its own future.

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Comments

  • Jim Wheeler  On April 25, 2011 at 7:47 pm

    You seem to be asking for government price controls here, JH. If that is the case, there is ample historical precedent that they backfire, big-time. Richard Nixon, a Republican, found that out the hard way. Here is a link, in case you’re too young to recall it like I do:
    http://en.wikipedia.org/wiki/Price_controls

    Jim

  • jwhester  On April 25, 2011 at 8:16 pm

    Well I was reluctant to suggest a solution since I feared my post would then become about the quality of my suggestion. My main point is that we need to do something that is likely to make free-market thinkers bristle.

    As it happens, price controls (like what has been tried) is not what I have in mind. I am thinking of something more radical. I am thinking along the lines of the Federal Reserve. Just as the government has the Fed whose job it is to manage the money supply for the benefit of the economy, I think we might need something like that for oil. I think it could manage that supply through various means (and price controls is not the first that comes to mind).

    We already have a strategic reserve of oil, but that is really targeted to the actual supply of oil. This is not a problem with supply and demand. My “Fed” would need to be more tied to futures contracts rather than to reserves of physical oil. I think there is a smart way to do this, but I doubt I am smart enough to design it.

    Of course there will be plenty who have a knee-jerk reaction to my suggestion. They will brand me with the “S” word and want to tar and feather me. What they need to do is carefully consider our situation and either argue that price volatility in oil is healthy for us, or they need to start thinking about solutions.

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